New M&A Rules to Encourage the Selection of Good Managers

Hostile Takeovers Arrive in Japan

Ever since the 2005 takeover battle for Nippon Broadcasting System, hostile takeovers have become a reality facing the Japanese company. A series of court decisions, especially the ruling by the Tokyo High Court in the NBS case and the 2007 fight to acquire Bull-Dog Sauce, maker of a popular brand of Worcestershire sauce, heralds a welcome trend in a shift of modus operandi of Japanese economic policy from ex ante guidance by government bureaucracy to ex post judgment by legal authorities.

Unfortunately, the court verdicts thus far have not adequately addressed the essence of the acquisition of companies, leaving both corporate managers and investors without firm guidelines to follow. The legality of the takeover defenses many companies have erected remains in doubt, and some companies are opting for defenses that detour the stock market by, for example, having friendly shareholders hold large blocks of shares in cross-shareholding arrangements. Perhaps because of such moves, investors in increasing numbers both at home and abroad have removed Japanese shares from their investment target lists, and the stock market has become sluggish as a result.

One option is to wait until the situation stabilizes through a buildup of court rulings. The conclusion we have reached through intensive discussions and extensive research in our Tokyo Foundation research group, however, is that legislation should be speedily enacted to spell out acquisition rules. The Japanese economy has already lost a precious decade in the 1990s after the bubble economy collapsed, and it cannot afford to lose another one.

We have started from the fundamental principle in economics and jurisprudence that the primary raison d'être of the corporate system is to produce added value for society and contribute to the development of national wealth (broadly viewed as the well-being of society in general) and redefined corporate acquisition as "a competitive mechanism for the reallocation of managerial resources"—one that works through the stock market to select the company's managers.

A good company is thus one that adds the maximal value to the society and good managers are those who maximize the added value the company generates. Viewed in this way, a good corporate acquisition is one that leads to the selection of good managers who are capable of enhancing added value, hence promoting the nation's economic or social wealth.

Giving Shareholders a Voice through Proxy Fights

We propose two institutional reforms. The first is to make the procedures for transferring controlling rights of a company more transparent and efficient (Proposal 1). With regard to voting in shareholders' meetings, the board of directors should be empowered to establish by resolution the condition that only shareholders with less than 20% of the total number of issued shares have the right to vote. (This resolution must, however, have the approval of shareholders already holding 20% or more of the shares, if there are any, and it cannot be made after one or more other shareholders have declared that they aim to take control of the company.) The board should also be empowered to remove this condition at any time. In addition, takeover bids based on proxy fight victories should be granted approval, and the offering period for TOBs should be extended from up to 60 business days at present to up to 120 business days.

The second proposal is to encourage the introduction of multiple classes of shares (Proposal 2). A company should be allowed to list various classes of shares designed to reflect its own conditions, including listings limited to multiple-voting shares or nonvoting shares.

One currently popular antitakeover tactic is the American-style poison pill that tries to discourage prospective buyers by a threat of diluting their stake. The company responds to takeover moves by giving advance warning that it will dilute share ratios by making a free issue of equity warrants to existing shareholders if and when a buyer has acquired, say, 20% of the shares. If the buyer requests an injunction against this tactic, its legality will be contested in the courts.

Under Proposal 1, a prospective buyer holding 19.9% of the shares of a company with the voting rights resolution in place would know that the acquisition of any further shares would result in the loss of voting rights. This would automatically set up a table for negotiation between the buyers and existing managers. If the talks lead to a compromise, and the board rescinds the voting rights rule, the deal would then become a friendly takeover. If the talks break down, a proxy fight would begin, and a general shareholders' meeting would decide which management team should run the company. In the meantime, the buyer would be allowed to continue the takeover bid on the premise of a proxy fight victory.

Theoretical Grounds of the New System

The ordinary trading of shares is a mere exchange between the buyer and seller, and no value is created. It is no different from buying and selling an apple in a grocery store, and elaborate regulatory rules are not required. This is not the case when the right of management control changes hands, however. Depending on whether the management team selected is capable or not, the value the company creates will greatly change. For this reason, a fair and efficient system assuring that managerial resources are appropriately distributed needs to be designed with care.

What would be a good system? The existing framework provides for changing controlling rights only as a result of a takeover bid, so there are no incentives to choose good management. This is because when a takeover bid occurs, existing shareholders decide whether to sell their shares based only on the offered price. After selling their shares at a high price, they will no longer have an interest in how the company performs. In cases where takeover bids succeed, it may turn out that the new management team had overestimated its managerial abilities or that the existing shareholders had underestimated the abilities and strategies of the old team. If the new managers are inept, the value created by the company will diminish, and even after the new team is replaced, losses suffered by the company's stakeholders, including minority shareholders, creditors, employees, and business partners, may never be recovered.

By contrast, when negotiations between current management and prospective buyers break down, our Proposal 1 allows the management team to be selected through a general meeting of existing shareholders. In this respect, the proposal would encourage shareholders to exercise their right to vote at shareholders' meetings.

Proposal 1 also includes an incentive for encouraging existing shareholders to select good managers. A proxy fight would take place between current managers and prospective buyers prior to a shareholders' meeting. The point to note here is that the existing shareholders would still be shareholders after the proxy fight is settled. For this reason, they would be compelled to make a selection between the competing management teams from a longer-term vantage point, taking into consideration managerial ability, business plans, employment policies, and other matters. Needless to say, buyers of the greenmail type, who have no intention of actually running the company, would be given scant consideration.

Unleashing Corporate Ingenuity to Increase National Wealth

Proposal 2 is a means of encouraging diversity in corporate governance. The Japanese economy is going through a transition from industrial capitalism, where one needs merely to construct a plant to generate profits, to postindustrial capitalism, where profits will be realized only by offering something different from other firms, such as through technological innovation or product differentiation. Only human beings can create such differences, but once something new is created, it will be imitated sooner or later. In the midst of competition between alternative technologies and imitated products, no single individual has the capacity to give birth to an unending stream of distinctive technologies and products. This can only be accomplished through the organized power of many individuals working together over the long term. The key to creating added value is building a distinctive organization, one that can foster human resources possessing original knowledge and know-how.

The direction in which corporate governance is moving can be seen in the management of Google, a leader in postindustrial capitalism. It has issued two classes of shares, class A and class B, and only the former, which has reduced voting rights, is traded in the market en mass. The division into classes is a stratagem to differentiate between shareholders who invest from the long-term perspective and those whose primary aim is to earn short-term profits. The class B shares go to shareholders who are interested in sustaining and developing the company over the long run. Their presence is a prerequisite for giving an incentive to intellectually oriented employees to acquire original knowledge and know-how for the organization.

Proposal 2 would open the way to this kind of corporate governance in Japan. It represents an attempt to secure diversity in organization types in a market-friendly way. Although special resolutions at shareholders' meetings would be needed to set up share classes, good managers would be able to find a way to do so to enhance their company's added value and contribute to the enhancement of national wealth.

The original Japanese article appeared in The Nikkei, February 6 2008. No reproduction in any form of this article is allowed without the prior written approval of the Nikkei Shimbun.